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I am neither a lawyer, accountant, nor a certified financial planner. If any ideas seem interesting to you here, please discuss them with your professionally licensed advisor before acting upon them. Otherwise, use them at your own risk.

Saturday, August 19, 2006

Should you separate your retirement and non-retirement accounts into two different portfolio strategies?

This is a very important question -- one with which I am struggling greatly.

When I realized I was not reballancing my retirements accounts on a regular basis - actually NEVER reballancing them. I decided to put my retirement savings into Life Cycle accounts that automatically reballanced and adjusted asset class allocations based on my age.

As most of my retirements accounts are with Schwab, the decision was fairly simple -- I put them into SWERX, Schwab's 2040 targetted life cycle account. YTD returns have exceeded it's category average by 1.03% and it's index by 0.45%. At the moment I'm fairly pleased with it. However, the underlying funds are more likely to be actively managed than passive, which means overhead and expenses are diminishing my returns. It would be interesting to compare SWERX with Vanguard's life cycle products - over time Vanguard's lower expense rates (I believe they have mostly index products in their lifecycle funds) should outperform Schwab's. Of course if I added up all of the expenses I'm paying for Schwab's lifecycle funds, 12b-1 fees, commissions the funds pay and other unreported expenses (market impact), moving my investments to DFA might make more sense - even if I were to include the mandatory advisory fees. However, that is another discussion.

The key topic here is this:

Should I manage my investments as two separate portfolios with two separate strategies, each with their own separate asset allocation strategy?

Option 2:Have two separate portfolio strategies. One for retirement - basically put it on auto pilot - and another for non-retirement accounts.

This is a very serious issues as my retirement accounts outsize my non-retirement holdings by almost 17 or 18 times (most of my non-retirement holdings are still illiquid with variable insurance policies - hopefully they will be liquidated before year's end).

If I go with option 1, I will be basically altering/supplementing the Schwab asset allocation strategy to achieve my own asset allocation model; i.e. I'll be adding various ETFs to bring my overall allocation plan closer to whatever %'s I set for each asset class. Therefore if Schwab seeks to lessen international exposure while I plan to increase it, most of my non-retirement holdings will pour into international asset categories.

Does this mean I would be second guessing Schwab's professional investment analysts - it looks like it. It also means that I may be grounding allocation decisions based on Schwab's periodic reporting of investments - therefore they may have changed their investment mix before I recieve an update. 1 point toward using two separate models.

On the other hand, my aggregate investment performance (what I get at the end of 30 years) will directly reflect all of my investments combined together. 1 point toward combined models.

However, my non-retirement accounts are very small - one may argue - too small to be meaningful or effectively rebalanced. I cannot change Schwab's asset allocation model, but I can reballance within my own non-retirement accounts, therefore, I need to have multiple asset classes within my non-retirement accounts to rebalance. The great disparity in size between my retirement accounts and non-retirement accounts may so deeply minimize certain asset classes presence in my non-retirement accounts (perhaps ones over represented in SWERX) that I will not have enough holdings in those classes to rebalance to or from. 1 point against combined models.

At the moment it makes sense to invest my money in two separate portfolios, however, ultimately I should really consider a move to DFA.

Altruist, a money manager that uses DFA charges 0.6% of assets under management. Most domestic DFA funds run expense ratios of 0.25% - 0.35% with some of the more unusual international asset classes running up to 0.9%, which is still quite low compared to the average mutual fund. Ultimately the average fund fee would be at or under 1% when incorporating the 0.6% asset management fee from the professional advisor - which is comparable to what Schwab is charging me to manage it's life cycle fund (plus any hidden fees 12b1 etc...). If I used DFA and a professional investment advisor I would have a single plan that aggregated all my retirement and non-retirement investments. The transparency of the account holdings would facilitate effective coordination between the two accounts.

One small pause - and this must be answered with more research - is that I'm unsure how DFA addresses the issue of fundamental indexing - they certainly have numerous value oriented indexes - even ones that are not normaly available. If I go with DFA am I abandoning this interesting investment approach? Does it matter? Has it even proven itself?

Now back to the current matter - it looks like I should manage my retirement and non-retirement accounts as separate portfolios each with their own asset allocation strategy. Consequently, I'll post my allocation strategy and holdings for my non-retirement accounts and incorporate it into a monthly review soon.

As I progress through William Bernstein's The Four Pillars of Investing, I'll modify my approach with lessons learned.

Are you in this situation now? Have you had to deal with this issue? If so, what decisions did you make, please share!

5 comments:

I am working towards similar goals as you are. Here are some of the approaches I use on balancing accounts.

Personally, I don't like to use retirement mutual funds, because I like to do my own investing.

I invest in CDs in my retirement accounts. That's because interest is tax free retirement accounts (and has no tax breaks in non-retirement accounts). And one can get up to 6% now. I invest in stocks and municipal bonds in my non-retirement accounts. I put part of my stock investments with a financial adivsor that uses well known professional management (for a fee) and part I invest in myself since it is my "hobby."

By the way, I NOT counting my home as part of my net worth. I only count assets that can generate income (cash, stocks, bonds and income generating real estate) when I retire. My home won't, unless I sell it, and will usually cost me money (taxes, maintenance).

In summary, for my non-qualified assets I have a "moderate growth" strategy; for my 401(k) assets I have a moderate growth strategy with a bit more risk, but less than an "aggressive growth". Both accounts have some common funds, yet the overall portfolio reflects the separate strategies.

Some demographics: I'm 60 yo, rertired for 5 years. Net worth about $4MM. No dependents.

I also employ Charles Schwab, as an "Institutional" client with about $3MM under management there. I invest in mutual funds almost exclusively.

Basically I think it comes down to time horizon and tax issues. Retirement account for people in their 30s and 40s have a natural long horizon and so that should usually mean they could take on more risk in those investments in theory (limits on how much can be contributed though might suggest taking less risk though...). It also means that one might allocate more in a retirement account to strategies that would be taxed more heavily in non-retirement accounts. This includes interest bearing instruments but also active trading! Bottom line is there is clearly a justification for different strategies. But in most cases they probably shouldn't be radically different strategies. I don't think you want to stuff the retirement account with interest bearing but low growth assets just for tax reasons, while doing supposed LTBH in non-retirement also for tax reasons when maybe you will actually end up using the non-retirement money first.

Personally I have 3 retirement accounts:

1. Australian Superannuation account - about 40% of net worth. It is parked with an Australian fund manager and all in one fund - currently a diversified fund. When I think market conditions are right I will switch to a more aggressive stock fund.

2. US 403(b) with TIAA-CREF - in two funds - Real Estate which has been a great performer and their bond fund which I switched to from Global Equities. Again at some time I will switch back to the Global Equity fund.

So both these use mutual funds in long-term market timing strategies.

3. US Roth IRA. Currently this is a money market and put options on the QQQQ. I also have held GLD in there and Yahoo briefly. So I very actively and aggressively trade this account. I put $8000 in from February through April and now have $13000 so so far so good.

My non-retirement accounts have a combination similar strategies with small differences.

Super Saver brought up the idea of hobby investing. I anticipate that my trading account will domicile hobby trading - but quite frankly it will be trading indexes more than specific equities and I'll really be modelling different passive portfolios rather than actively trading.

moom, my retirement accounts house almost all of my bonds (via the life cycle fund). My trading account is more or less pure equities.

I'm not sure how to integrate my prosper.com accounts into the picture, but they perform more or less as bonds (junk bonds?). They do not sit in taxable accounts - I'm not sure prosper is structured to support it. At the moment our retirement assets are in the fairly aggressive stage of the life cycle.

Actually, my trading account (non retirment) allocations probably push themselves into the higher risk area as well, however, they're long term investments.

I anticipate about 30 more years before I touch either investment.

Thanks for the thoughts gentlemen, as mentioned, I continue to lean toward separate strategies until I establish an integrated plan -- possibly with DFA and a financial advisor.